dollar bills

Why do we need banks and what is their role in society? Can a financial system operate without banks? How do banks become interconnected as part of their regular lending activities?

These are some of the questions that MIT fellow and founder of Stronghold Labs, Alexander Lipton, asks in a paper on modern Monetary Circuit Theory (MCT), the idea that money is created by the commercial banking system in the form of credit with central banks as mere system stabilisers and liquidity providers. While the private enterprise approach can be mismanaged and appears chaotic at times, the latter leads inevitably to central planning and using "supernatural abilities to figure out how much money is needed in the system".

Lipton is deeply interested in digital currency and blockchain technology, which he sees as a catalyst, a way of combining elements of MCT with narrow (full-reserve) banking.

Because central bank cash does not play a significant role in creating money, it should be possible to tokenise it and use it more efficiently. This could be the first step to a restructuring of the financial system: firms and ordinary citizens could hold accounts with central banks; commercial banks would lose their central position in the economy and become utility providers and know-your-customer (KYC) gateways (again using blockchains).

Since 2008, many central banks have massively increased their balance sheets while commercial banks have chosen to keep enormous quantities of non-mandatory deposits with them. Thus, the system de facto has moved towards narrow banking, notes Lipton.

He said: "It is extremely healthy and beneficial for the banking ecosystem to have a few narrow banks and that is something I'm pursuing as one of my projects. This will increase the competition in the banking system which will become more stable and trustworthy as a result.

"However, I don't think that we are ready for, or would even want to have, the entire banking system as a narrow one."

Lipton's interest in DLT-based central banking has led to his involvement with the Utility Settlement Coin project (he is an adviser to its technology provider, Clearmatics).

"There are potential improvements in the speed of execution and general banking if one were to tokenise central bank cash and that interests me as far as Clearmatics is concerned. More generally, ideas related to narrow banking and things of that nature are central for the future of the whole digital financial system.

"Moreover, at MIT we are also developing digital trade coin with some colleagues which is aimed at facilitating trade and has a backing with real assets. So a similar concept to USC, but broader in the sense that other assets than just cash are used as collateral."

Smart contracts and collateral

Lipton has a nuanced view of how and where blockchain technology can be best applied to the financial system. For instance, he does not think DLT is such a productive idea for trades that involve a long-term commitment between counter-parties, such as swaps.

He believes straightforward stock trading could probably be improved, but that the jury is still out as to whether the perceived advantages of blockchain in that context actually outweigh the disadvantages.

"When ownership does not really require a long-term commitment so to speak then I can anticipate some advantages," he said. "But it's not 100% clear to me that gross settlement for shares and things like that is really such a great idea either."

As well as central banks looking at DLT, there are pockets of progress being made on blockchain clearing of stock trading (DAH and ASX) and also common standards for smart contracts to handle instruments like swaps (ISDA). Lipton said he had reservations about smart contracts which he described as "voracious consumers of collateral".

He said: "Smart contractisation, if you think about it, in some respects brings us back to medieval times. When people would play dice in a tavern and all of them were cut-throats, nobody trusted anyone else. But they were able to sort this by actually putting cash on the nail – which is where the expression comes from.

"We don't need to know each other; we can play dice as long as all the gold is on the table. That's how smart contracts are designed, at least when they operate in a sort of un-permissioned blockchain."

Following a similar thread, an ideal held in high regard by libertarian cryptocurrency stalwarts is the end of fractional reserve banking.

"Although I have built a detailed mathematical theory of fractional reserve banking and do appreciate some of its merits and nuances, I don't think that it is the only solution, especially in the digital era," said Lipton.

"I lean more towards a mix of fractional and narrow banking. My basic take on this is that you have to keep some fractional banks in order to have a growth in the monetary supply because otherwise the economic system would be choked.

"It's a deeply unsatisfactory idea to have a fixed or diminishing monetary supply, which is a basic premise of some digital currencies, such as bitcoin. At the same time, narrow banks are badly needed in order to increase competition by challenging the incumbent banking business model and making the system more stable and efficient.

Private enterprise v central planning

"There are two essential mechanisms for finding a plausible way of increasing the monetary supply. One is through fractional reserve banking where commercial banks create money out of thin air. Banks pursue their own narrowly understood interests. However, by applying their systemic collective wisdom (or lack thereof, depending on the situation), as a system they operate close to optimal fashion most of the time.

"The other possibility is to relegate money creation to central banks. I just don't believe that central banks are even remotely equipped for this endeavour. I prefer private enterprise to central planning. Removing fractional banking completely would, in the end, result in a type of central planning."